Details and Shortcomings of NuBits

One week ago Digiconomist speculated on what Peershares secret project NuBits could look like. NuBits was announced as “the most important development in the cryptoasset space since Bitcoin was released” and claimed to “completely solve the volatility problem cryptocurrencies have experienced.” This left only a limited set of possibilities, but the NuBits team seemed to deny that any of these would be part of NuBits. But when NuBits was finally released this week, it turned out that the prediction was not that far off.

One of the listed possibilities was that volatility could be reduced through controlling monetary supply. Even though this did not seem realistic, it is exactly what NuBits tries to incorporate in order to keep the price of one NuBit equal to one Dollar. The way this done is, however, not very convincing.

Increasing Supply

When the prices rises above one Dollar, more NuBits will be generated to be subsequently dumped on the market until the price is back at $1. There is not anyone who will doubt the effectiveness of this. Strangely, NuBits’ answer to a declining price is also to generate more NuBits. These are used to reward USD liquidity providers, which should create a buy wall that stops the price from falling.

At the same time, NuBits tries to generate demand by offering interest on what is called parking. Parking means taking coins out of circulation for a certain period of time for which a percentage of interest is received in return. Despite the fancy name, it is identical to nothing more than a simple certificate of deposit.

As new coins are created to reward liquidity pools and to pay off interest, both methods will result in increasing the total supply of NuBits. As the supply increases, so will the number of coins being sold and therefore the pressure on the value of the currency will also increase.

Bad Incentives

Let’s consider an example where the price of one NuBit is at 90 cent. In an extreme scenario, 100% interest is offered for parking coins for a single day. Assume 1000 coins are bought at 90 cents for $900 in total. These coins are parked for one day and will have doubled the next day. The buyer now has 2000 coins which need to be sold at just 45 cents in order to break even. So despite generating some demand, in the end it provides an incentive to sell more than it generated. Of course, the same mechanism applies to normal cases with less interest offered.

On the other hand, selling coins when demand is high and buying them back when coins is low is a strategy that can provide some stability for a while. This will result in a (limited) reserve of dollars that can be used to create a buy wall. Unfortunately, because this resource is limited it creates an incentive to bet against the system. If an investor can short sell a NuBit at a price of dollar then there is practically nothing to lose, as the price will not rise above this level. When demand is low, these investors have the biggest incentive to start short selling the digital currency, as it offers the biggest opportunity that the limited reserves will not be able to hold. The coin is only helped by the fact that the current exchanges on which it is traded have not made short selling available. But this is also just a minor problem compared to the additional supply, and resulting inflation, created due to interest.

No Destruction

The only way to effectively increase the coin’s value (or negate the effect of interest) is by actually reducing the total supply through the destruction of coins. Thanks to Bitcoin, it is well known how scarcity leads to an increase in value. By destroying coins, the supply is decreased and made scarce. Sadly, hardly any destruction of coins takes place in the current protocol. Transaction fees are burnt (destroyed), but these are too low to compensate for the increase in the total supply. Raising transactions fees would not make sense either, because one of the big benefits of cryptocurrencies is low transaction costs in the first place.

Conclusion

In short, NuBits uses increases in its total supply (through various ways) and thus inflation as the only method to combat both an increasing and decreasing price. This might be able to hold for a while, but leaves nothing but a time bomb waiting to go off. The developers might have created NuBits with the best intentions, but until any adjustments have been made it is advised to avoid from this digital currency. A discussion on the discussed problem and possible improvements can be joined on the NuBits forum here.

NuBits relies on interest rates to (attract new demand and) restore the price level. In theory, it is more flexible than BitUSD because the latter restricts short selling below a certain level. This could be better for price stability, but it does not increase demand. Sellers could face a lack of liquidity and get trapped in their position.

Shorts will therefore typically outnumber the buyers, and cause the price to bump below the median price over a certain period (if I understand correctly, this is what determines the restriction level). This might lead to a downward trend in the long run.

In any case, the biggest immediate problem for BitUSD will be a lack of liquidity on the buy side – hence I would actually prefer NuBits.